Threat of a bear market is gut-check time

Gail MarksJarvisTribune staff reporter

You've had a scare.

Not long ago, you watched the Dow Jones industrial average drop sharply--360 points one day, 223 another. If you were like many of the people who called me a week ago, you had sweat on your brow and wondered if you should sell your stocks and stock mutual funds immediately.

What a difference a week makes. No one is calling now.

Stocks have rebounded, and some analysts have declared the worst over for banks and other financial institutions.

These observers are less worried that the economy will be starved by lenders, who won't loan money because so many institutions have lost billions on the mortgage-related mess.

Still, other analysts aren't sure. Among economists recently surveyed by The Wall Street Journal, only 15 percent thought the credit crisis was over and 25 percent thought we were merely in the early stages of the problems. And there is still a concern that the economy could go into a recession as consumers struggle with housing debt and the slowdown in home construction affects companies and jobs.

So rather than being caught up in the optimism or pessimism of the day, turn your analysis inward.

You had a taste of how you would feel if we were headed into a bear market--a period in which stocks fall about 20 percent or more and stay down for a lengthy period.

Although this month's drop was only about 6 percent at its bottom, it provided valuable information.

If you were afraid you were going to lose too much money--money that you would need to get your hands on within the next couple of years--you might be taking too many chances with your investments.

If you said to yourself, "The market might go down 20 percent or more, and I won't like it, but I will stick it out and be fine," you may indeed be fine.

Investors are supposed to invest based on when they will need their money, and also on their gut. Those who chicken out after the market is down 20 percent or more harm themselves significantly because they lock in losses.

So now is the time to figure out whether you are likely to do that to yourself.

Force yourself to think about bear markets. They are a part of investing. Although the stock market tends to rise--or be in a bull market--66 percent of the time, it is in a bear market--or dropping hard--34 percent of the time, according to research by the Leuthold Group, a Minneapolis money manager that researches market history.

In fact, on average investors can expect a bear market to hit a low every 41/2 to 5 years. The current bull market began in October 2002.

During the last 100 years, there have been 22 bear markets, and the average decline in the stock market has been 37 percent, according to Leuthold. Half of the time it takes more than 20 months for investors to regain the money they have lost. In some bear markets, such as the 49 percent drop in 2000-2002, it can take much longer. Investors didn't get back to even until this year. It was similar to the decline of 1973-1974, when investors didn't get back to even until 71/2 years later.

Although financial advisers want investors to envision bear markets so they realize that stocks can drop hard, they also emphasize that the right mixture of investments can carry investors through the hard times.

Ibbotson Associates of Chicago has researched how various portfolios have held up during bear markets. In fact, when they looked at the worst five-year periods between 1926 and 2005, they found that an all-stock portfolio has averaged a 12.4 percent decline per year. Yet a portfolio that contains 70 percent stocks and 30 percent bonds dropped just 6.3 percent on average. Investors dividing their money 50/50 averaged just a 2.7 percent loss, and with only 30 percent in stocks and 70 percent in bonds, even those worst periods did not delivered a loss.

This is why financial advisers suggest that people who will need money soon keep that money out of the stock market. It is why advisers often suggest that new retirees keep no more than 60 percent of their investments in the stock market, and for people later in retirement to keep only about 20 to 30 percent in the stock market.

"Investors should be analyzing their portfolios now because we could be in the early stages of a decline," said Lewis Altfest, a New York financial planner.

For help in establishing a mixture that is right for year age and gut, try one of the many "asset allocator" tools on the Internet. You can find one at www.smartmoney.com.

Besides getting the overall stock and bond mixture right, Altfest said, investors should make sure that no more than 20 percent of their stock portfolio is invested in small-cap stocks. Stocks of small companies tend to do poorly in recessions and also have been so popular during the last seven years that their prices are vulnerable to fall. In addition, Altfest warns investors to avoid emerging-market funds, which invest in developing areas such as China and Brazil. After climbing more than 400 percent over the last five years, they too could fall hard in a downturn, Altfest said.

In addition, he warns investors to avoid high-yield bond funds, which invest in risky corporate bonds that will likely decline if the economy weakens.

After finishing that type of portfolio overhaul, Altfest said there will be no need to make changes during a recession or a bear market. But if you find your portfolio is still too much for your gut during a time of stress, Altfest offers what he calls "a sugar pill."

"Cut back stocks about 5 percent so you feel better," he said.

It's not necessary, he said, but if it helps an investor hold on to wait for a recovery, then it's the right move.

Gail MarksJarvis is a Your Money columnist. Contact her at gmarksjarvis@tribune.com.